Durable businesses key to Japan success

Mike Lindsell, 44, has recently taken over management of the Close Finsbury Japan fund. He left Invesco in 1999 to set up Lindsell Train. At Invesco (formally GT Management), he managed global and international funds, and was head of the global product team. Lindsell moved to GT from Warburg Asset Management in 1992, after starting his career with Lazards in 1982. He studied zoology at Bristol University.

Q: How do you select stocks?
A: We try to invest predominantly in companies that we consider durable businesses. People in this industry tend to promote the view that the durability of stocks is more than evident. Yet in the majority of Western indices, it is only a very small proportion of companies that are still there from 20 years ago. A lot of businesses simply aren’t that durable. They are bought, taken over or go bust.
If you compare these indices to the index in Japan, the businesses look a lot more durable. From 1983 to 2003, 66% of the companies in the Nikkei were the same. The main reason is that Japanese businesses have had investments in each other through cross-shareholdings. This has helped to preserve businesses in their current guise. The recession has also been a contributing factor.
Cross-holdings have now fallen from around 50% to around 35% of the market. This is likely to accelerate. As that occurs, businesses will be more vulnerable because they don’t have the protection. So the overarching change in the Japanese market is that it is going to get less durable.
The number of genuinely durable businesses is therefore quite small, so we run quite concentrated portfolios. At the moment, we have around 22 stocks.

Q: What makes a business durable?
A: We want to be confident that the company will be around in the future. We want some comfort that the cashflows are safe. We want a company that remains stable in a deflationary environment and grows more than inflation in an inflationary environment. We believe history can be an indicator or a predictor.
For example, the Japanese have been drinking Kirin beer for years, so we hold Kirin Brewery. History is where you start. Our top 10 holdings tend to be established companies such as Nintendo, Canon or Fuji Photofilm. These are durable businesses.
We like good consumer franchises that have good recognition from customers, particularly where there is one big-ticket item and then a lot of incremental expenditure. It is a repeatable business model; an example would be Canon, where the main product is the printer. This is quite low margin, but as soon as the investment is made the customer has to buy printing inks and toners. Around 80% of the company’s profits are from this sort of consumables. This is repeatable – it is guaranteed follow-on sales.
We like investment in essential services, such as educational businesses. It is a priority for most parents; they don’t ask the price, they just pay.
We also have a number of investments in less durable companies. Some companies have the cash or financial backing for us to be tolerant.
There are a couple of businesses with net assets of twice their market capitalisation. We get the business for nothing and the assets for half-price. In these sort of stocks, our holding period tends to be shorter. Around 7% of the portfolio is in this type of stock at the moment.

Q: What is your sell discipline?
A: We want to invest in durable businesses only if they are underpriced. We value every company and that valuation determines the share price target for a company. If a company’s shares rise to that level, that provides our sell discipline.
Of course, we may make mistakes or the business can change. For example, we like to access virtual monopolies. These can be broken and we would then have to reassess the price target and valuation. Our estimates of the durability of cashflows may also turn out to be wrong.

Q: Where are you finding opportunities at the moment?
A: There are some businesses that we are looking at, like Kao Corporation, for example. This is the Procter & Gamble of Japan and sells a range of household goods. It generates good free cashflow. It was trying to buy the second largest cosmetics company, but has had some union trouble. This has caused the share price to fall back and may provide a buying opportunity.

Q: How have you changed the fund since taking it over?
A: There has been quite a lot of change, but it is all done now. We had a very clear idea of how we wanted to run the portfolio and put that strategy in place straight away. We just did one big programme trade.

Q: Does your style perform better in some markets rather than others?
A: It may not perform in certain markets. We like businesses that are cash-generative and have strong track records. So we would probably underperform in a market that is buying very cyclical stocks or is tolerant of high leverage.
We focus on the bread and butter of return generation. More usual is that I go through bursts of performance. It is not so definable and can happen at any time.

Q: Is there an optimum size for your fund?
A: No, our process is pretty scalable. Because we have a large-cap bias, there are no real size restrictions. There might be a practical limit, but that is tomorrow’s problem. It is a long way off yet.

Q: Do you think the Japanese markets can continue their strong performance in 2004?
A: I don’t have a massive view on it. The markets have been rising on the back of a lot of companies where earnings have improved. That has now been priced into stocks. I think there will need to be an incremental improvement in earnings to see further strong rises in markets.

Q: Is the economic situation improving?
A: Exports are strong. That is only a small part of the economy, but it has certainly helped the economy over the past year. The yen has been strong and at the margin, this will temper growth. Deflation is still present. It is a half-full/half-empty glass sort of situation.

Q: Is the Chinese situation a help or a hindrance?
A: A lot of the increase in exports is due to demand from China. But at some time Chinese imports will be undercutting them, which will have a deflationary effect. Overall, it is a net positive. China is growing faster than Japan.

Q: Is there any lesson you have learned in fund management that has been particularly valuable?
A: The most important lesson is to focus on dividend-paying companies. These are companies that can distribute rewards to shareholders.
It has generally been the case in Japan that dividends have not been important. I think they will become more important in the future.